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Portfolio management What is an investment? Sacrifice of present consumption for expected future return. Why do we invest?

While investing, one should have a view on the expected return that a person is expecting to gain from it. Lot of individuals invest blindly, without defining any return expectation. As professional portfolio managers, you shouldnt do the same. A clear view on the objectives of investing and expected return is very necessary.

Specification of investment objectives and constraints.

Choice of asset mix

Formulation of PF strategy

PF execution

PF revision

PF evaluation

Step 1: Specification of objectives and constraints: For this, one should first define the objectives of investing and constraints. These get defined in the investment policy statement. The policy statement fixes up the scope of investing, the actions to be taken by the portfolio manager in a disciplined and defined manner. The policy statement should cover the following: - objectives of investing - constraints in investing - the scope of investing - various asset classes and possibility of investing - the expected return - Benchmark for performance - could be an index or inflation return or anything else. Objectives of investing How can objectives be defined? Can we just say that the objective of the PMS is to earn a good return? hell no! it has be precisely defined. In doing so, an exact relationship between the risk and return has to be established. Is your objective going to be maximization of return or minimization of risk? Income, growth, stability are 3 usual broad objectives of a PMS. It should be clearly defined. Some examples: Capital protection can be the chief objective of the PMS, where aggressive return-earning strategies are sacrificed for conservative strategies, where risks involved are lesser. Investment in high-risk-high-return stocks could also be a strategy. Whatever it is, clearly define it and follow it. If tomorrow, an opportunity comes by, which does not fit into your PM objectives, you should ignore it totally. Constraints: these are factors which prevent a person from investing in a particular asset class. e.g. liquidity, investment horizon, taxes, regulations, unique circumstances. You might want to invest in a particular asset, but these constraints stop you from investing in them. Why is it essential to identify ones constraints? Identification of goals: Every investment targets a goal. The goal determines the type of investment that an investor is making. Short term-high priority goals: absolutely necessary to achieve these goals. E.g. include paying margin for a house, saving for an upcoming marriage. The individual has a high amount of emotional involvement in these. So the money set aside for achieving these goals is generally invested in highly safe and liquid investments.

Long term-high priority goals: goals such as planning for education of child, achieving financial independence on retirement etc. since the goals are long term, higher amount of risks can be taken. Reasonable amount of diversification is also possible. Low priority goals: if an individual doesnt attain these goals, it would not affect him materially. E.g. going on a foreign tour. Usually, since these goals are satisfied with the money which is not required for high priority goals, investors generally tend to invest it in speculative investments. Moneymaking goals: for individuals who are not satisfied with attainment of the regular goals and would like to attain something more in life. People with entrepreneurial frame of mind tend to pursue these goals. E.g. goal to establish own consultancy business. People tend to set money aside to invest in such ventures and monitor it regularly. As an individual investor or a portfolio manager, one needs to assess the goals carefully so that investment can be made accordingly. E.g. money meant to satisfy short term high priority goals should not be invested into equities since the risk associated is too high. E.g. house-loan disbursement invested in F&O. Once an individuals needs, goals and constraints are identified, it is essential to formulate an investment policy. The IP is influenced by the multiple factors discussed above. There are three ways in which one goes about this. - absence of policy - traditional policies - multi-asset policy Most of the individual investors end up following the first option. When asked why you are investing, the answer you will get is to earn good return. They have no idea as to what is a good return or how they are going to earn it. They end up investing in totally wrong asset classes and lose money frequently. The traditional policies can be further classified into income, income & growth, growth, aggressive growth. In the income policy, the general belief is that only the income from investments can be spent/ withdrawn, while the capital gains on the investment are meant for reinvesting. The second policy is a combination. The third policy entails investment mostly in equities, while the fourth goes for extremely risky and volatile asset classes. Multi asset policy is extremely flexible policy. Requires superior skills and flexibility.

Asset allocation types Strategic asset allocation Long term in nature-done after every 3-5 years. Basically consists of taking an overview of all the asset classes and the market conditions, in order to study the need to shuffle or rearrange the existing asset allocation. It could be the case, that since equity investments have substantially increased in value, their proportion to the total portfolio has increased quite a lot. So, it may become necessary to take out some profits and invest in debt. This analysis needs to be done. Necessary to make long term predictions about the capital market. More of a macro-analysis. A call on the risk tolerance levels and return perceptions of the investor also needs to be taken. Tactical asset allocation More of a routine activity. The focus here is on taking advantage of any inefficiency in asset classes, in order to earn optimum return. There is no emphasis given on the investors risk tolerance or return preferences. Eg. bonds have given super normal returns over the last 1 year. So, 1 year ago, if any portfolio manager had the correct view about the interest rates, he would have shifted from equities to bonds. What does this imply? Assumptions behind going in for this entire process 1. the markets provide explicit information about available returns 2. the relative expected returns reflect consensus 3. expected returns provide clues to actual returns Some other asset allocation approaches: The Layman approach: very fluid, not defined, based on factors such as gut feel. 100 minus your age! Dynamic strategies for asset allocation - buy and hold strategy Divide your portfolio into parts, like 60:40 equity:debt. This is at the time of initial investment. Now, after investing, dont change it. Let it remain. New money coming in is to be invested in the same proportion. In this case, your portfolio will never lose more than 60% of the value. - constant mix First decide upon a mix of the assets, e.g. 60% in equity, 40% in debt. Decide upon a review date, e.g. 1st of every month. So, upon review on the 1st of every month, your job is to maintain this 60:40 ratio.

Now, how do we do it practically? Four steps to be remembered while formulating a portfolio policy: Selection of proper asset classes Mix of these asset classes Range allowed for each asset mix Risk level of securities in the asset classes Formulation of portfolio strategy 2 main choices: active strategy and passive strategy. Active strategy: Followed by most professionals. Four aspects to it: 1. Market timing: taking a call on probable market movements to buy/sell switch from stocks to bonds. Not worth the risk in my view. 2. Sector rotation: keep investing in sectors that you feel are going to become the happening sectors. Once the market also discounts it and prices rise, exit and invest in another sector of tomorrow. E.g. IT, power, real estate are sectors which have had their time in the limelight. Now, water management, environment protection, education, defence can become tomorrows hot sectors. 3. Security selection: pure bottom-up approach. Keep on looking for undervalued securities. Once you are convinced about the potential to buy, invest. Keep switching by selling securities which become overvalued and keep on buying undervalued securities. 4. Use of specialized concept: Growth stocks, value stocks, asset-rich stocks, technology stocks, cyclical stocks, momentum stocks. Meaning of each? Portfolio revision: Portfolio revision is an essential and critical part of the process of portfolio management. Not going in for formal portfolio revision from time-to-time may result into Holding a portfolio or an asset that is overpriced and hence will return into inferior returns The composition of the portfolio may no longer reflect the objectives A poorly diversified portfolio, which entails more risk than necessary. This is a task where a fine balance has to be maintained. On one hand, it is necessary for the portfolio manager to get rid of stocks which are not expected to perform well in future. On the other hand, he has to take care that he does not go overboard in this activity, since it will increase transaction costs and eat away into the returns.

Need for portfolio revision / rebalancing Change in the financial position of a client: as the client gets richer (or poorer!), his risk taking ability and expectations about returns keep on changing. E.g. a person who has a portfolio size of Rs.100 crores will expect a lower return on his portfolio, than an individual whose portfolio size is Rs.50000. As the portfolio grows bigger, it becomes difficult to deploy it in the same fashion as a smaller portfolio. E.g. Buffet with his $40 billion cash.. Change in the clients investment time horizon: an unexpected event or a major expenditure, such as marriage may force the client to change his investment horizon, and the portfolio manager will have to rejig the portfolio accordingly. Change in liquidity needs: the client may demand higher liquidity in the portfolio, with change in market conditions. E.g. current market scenario. As a result, the portfolio manager will have to increase the cash component in the portfolio. Market sentiments: bull and bear markets. Changing return prospects: bonds-equity-bonds

Pitfalls to be avoided in portfolio revision: Some portfolio managers believe in churning their portfolio continuously, as dictated by their emotions or judgment. There is no proper discipline as to how and why switching is made. Some common pitfalls in portfolio revision are: Obsession with tiny market movements and excessive trading Projecting the past into future without analysis Cultural differences and peer pressure

Portfolio revision techniques: Formula plans: as the name suggests, these plans ensure portfolio revision through application of some formula, based on which the portfolio will be revised. They are highly mechanical in nature and ensure that portfolio revision takes place as necessary. These are not fool-proof, but are designed in making the portfolio revision process, automatic. The formula plans are based on certain predetermined rules. The rules specify the nature, timing and proportion of the change. The formula plans have their own share of weaknesses: They offer no suggestion on security selection They are extremely rigid and offer no flexibility due to changing circumstances. Framework: The entire structure is divided into two parts an aggressive and a conservative portfolio. The aggressive portfolio is designed to provide greater returns (greater risk too!) to the portfolio, while the conservative portfolio provides stability.

Typically, the conservative part of the portfolio will be composed of bonds. The conservative portfolio should have low volatility while the aggressive portfolio should have high volatility. Constant dollar value plan In this plan, before starting off with the investment process, a proportion for aggressive and conservative portfolio investment is decided. After the investments are actually made, the market value of the aggressive portfolio should be kept constant. If the value of aggressive portfolio rises, the investor should sell a part of his aggressive portfolio and convert it to the conservative part, and vice versa. There is an automatic switching from aggressive to conservative stocks, since we are selling the aggressive portfolio when the price rises and buying it when the price falls. Constant ratio plan The plan is similar to a great extent to the constant dollar plan. However, in this plan, the aim to maintain a constant ratio between the aggressive and the conservative portfolio. Unlike the constant dollar plan, we are not considering the market value of the aggressive portfolio alone, but the proportion between the aggressive and the conservative portfolio. Dollar cost averaging In practice, modifications are made in formula plans as per the market conditions. The modifications made are to delay the rebalancing action. E.g. current scenario. Discussion a security should be bought/sold on its own merits. Hence there is no need to view them together as a portfolio and hence, no need to go in for rebalancing. Does this make more sense? Practical procedure for rebalancing: Rebalancing is not only required between the stocks-bonds portfolio, but is also required even in the stocks portfolio. We have to rebalance our stocks portfolio as per the risk attached to a particular sector / company. Discussion.

Equity portfolio management: Two specific styles: Passive and active Passive equity portfolio management: One accepts that it is impossible to beat the broader market. Markets are efficient and therefore, the max return one can earn is the market return.

There are three different types of passive strategies: index funds, customized funds and factor funds.

Index funds: The simplest type of passive portfolio management strategy. Select an index, invest in the constituents of the index in exactly the same proportion. The return of the portfolio will mimic the return of the index. Only revision to be made is when the components of the index are changed. No question of benchmarking here, since you are investing in the benchmark itself! In India, almost every mutual fund house has an index fund scheme. Benchmark mutual fund has an ETF, NiftyBees, which is traded on the NSE which mimics the nifty return. Customised funds: In the regular index funds investing strategy, one invests in the per-defined index. Instead of that, one can construct ones own index also. The primary reason for this is that a ready-made index may not give the necessary diversification that an investor needs. So, he may construct an index of his own, and invest in it in his proportion. (Practical applicability for US pension funds, which do this due to legal compulsions. Applicability in India is zero) Factor/style funds: In this type of passive strategy, one can create ones own index, specifically tilted towards a particular sector, or style of investing. So one can have a growth stocks index/value stocks index/welding sector companies index etc. Diversification is not the main objective here. This acts as a substitute to the active strategies. Active strategies: top down and bottom up. Portfolio Evaluation How does one measure the performance in ones portfolio? For that the performance needs to be compared with something. This is known as benchmarking. A portfolio manager should select a proper benchmark to measure his performance. E.g. BSE Sensex may be selected as a benchmark. So if the portfolio performance is lets say 25%, but the sensex itself has gone up 40%, then the performance can be said to be bad. On the other hand if the portfolio shows a loss of 5%, while the index itself has gone down 20%, the performance can be said to be excellent.

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